Life is becoming increasingly harder for investors who rely on a steady stream of income to increase their retirement savings.
Uncertainty over Britain's role in the European Union and a global economy that can't find traction have investors flocking to the safety of bonds, which drives up prices and drives down yields.
Earlier this month the yield on the benchmark German 10-year bond dropped below zero for the first time in history, following Japanese bonds into the negatives. Benchmark lending rates in the United States and Canada are barely above zero, and that's putting a yield freeze on the entire bond market.
Eight years of central bank efforts to boost growth by flooding global financial markets with cheap cash have come up nil.
"We're trying to invest in a market that is witnessing one of the greatest distortions of natural capital markets I can see at any point in history," says Boston-based James Morrow, manager of the $2.5-billion (U.S.) Fidelity U.S. Dividend Fund. "You have to go back to the Great Depression to see anything similar."
What's worse, he says, the bond market mayhem is seeping into the stock market as cheap money fuels equity prices. "It's causing a lack of a reliable reference rate to filter through all the other markets including equities. You're getting that distortive effect in stocks as well."
Mr. Morrow's mission is to draw income from the stock market through dividends, which have been paying higher yields than bonds. "If you need a return to live and compound your retirement, you really don't have a choice of owning bonds right now. Your next best alternative is to go out the risk spectrum and buy stocks."
Over time, dividends can provide 50 per cent of a stock's total return, he says, but higher yields come at a price for income investors leaving the safety of bonds.
"You own the upside and a downside in the stock price. That's been lost a little bit in this process of trying to turn stocks into bonds. I think some investors have forgotten that there is inherent volatility and downside risk in stocks," Mr. Morrow says.
Income investors flocking to the stock market have increased risk by driving up some dividend stock prices, such as real estate, tobacco and utilities, he says. To manage that risk he has implemented a strategy to buy the best dividend payers at the lowest price.
"There are stocks that have 2- or 3-per-cent yields that are really expensive, and there are stocks that have 2- or 3-per-cent yields that are extraordinarily cheap," he says.
For example, he compares the Simon Property Group real estate investment trust (REIT) with IT manufacturer Cisco Systems Inc. Both pay a dividend near 3.5 per cent, but Cisco's cash flow has allowed it to boost its dividend faster. Over the past five years, Cisco's dividend has grown by 72 per cent, while Simon Property increased its dividend by 16 per cent over the same period.
He also compares the company's ability to generate cash to pay dividends to its current stock price.
"I can own that cash flow stream at a third the cost in Cisco Systems as I can in Simon Property Group, and I can get the same current income," he says. "If I think they're comparable I'm always going to buy the one that is a third the price of the other one."
The tech sector is loaded with companies with strong cash flow positions and low valuations, he says.
But even that level of risk management may not be enough for investors living on dividend income, says Paul Gardner, partner and portfolio manager at Avenue Investment Management in Toronto. His income portfolio is a mix of dividend stocks and bonds, but he recommends at least a portion of a portfolio always be set aside in bonds.
"Whether it's 1 or 2 per cent, you need asset allocation to keep your life stable – especially if you're older and you need the income," Mr. Gardner says. "If you go all-in on the stock market and suffer a large loss it could impact your life. Whether you like it or not, bonds are here to stay."
He says income investors looking to boost yield without taking on stock market risk should consider high-yield corporate bonds. Their yields have been rising in comparison to government bonds and creating buying opportunities when new bonds are issued and the prices fall on comparable bonds with lower yields on the bond market.
While high-yield bonds are riskier by bond standards, they are safer than stocks because they have a set payout date. "As long as they don't default, there's a maturity," says Mr. Gardner.
One high-yield bond with one of the best payouts and the least risk is Yellow Pages Ltd., he says, which pays 6 per cent and is set to mature in 2022. The print and online directory publisher recently restructured a mountain of debt to avoid bankruptcy. "There's very little debt on their balance sheet," he says.
One casualty of the restructuring was the generous dividend yield on Yellow Pages' stock, which at one point topped 30 per cent. While stock dividends can change at the discretion of the company, bond yields are secured by the company's assets.
Another high-yield bond in his portfolio is Baytex Energy Corp., which yields 10 per cent and matures in 2022. Plunging oil prices forced the oil and gas producer to slash its stock dividend, which sent share prices plunging 66 per cent over the past year. The stock has since recovered some of the loss, but Mr. Gardner says even if oil and natural gas prices fall again the company owns enough assets to back up its bonds.
"If the world ends we should get most of our money back," he says.